These Correlations Might Make You Reconsider Your Portfolio Exposure To Gold

Home / Commodities / These Correlations Might Make You Reconsider Your Portfolio Exposure To Gold

June 30, 2017

These Correlations Might Make You Reconsider Your Portfolio Exposure To Gold

Central banks are slowly introducing the markets to higher interest rates, but this is just due to inflation and thus the effect on gold will be positive.

Since 1971, the trend for gold, monetary policy, and government debt burdens is clear.

Portfolio exposure to gold of 7.5% should be seriously considered.

Introduction

Gold prices are difficult to forecast as anything can happen, but as I have already written about how gold should be a part of every portfolio because it is a perfect hedge for economic and monetary turmoil, I’ve decided to write about the current position of gold in relation to economic forces in order to better determine how much of a portfolio should be exposed to gold. You can find my reasoning behind owning gold miners in my article available here.

It’s important to look at long term gold correlations with interest rates, inflation, economics, monetary supply, and government debt levels. A long-term gold balance price will give us a good indication of whether to be overweight gold now, or if it’s better to have little exposure now and then increase if gold prices fall.

Gold Correlations – Money Supply, Interest Rates, and Inflation

I find the correlation between gold prices and money supply extremely important. Even if it isn’t perfect, it gives strong indications about long term trends.

As there was more liquidity in the monetary system, gold prices increased. Accounting for market panic—which is euphoria for gold prices—in 2012, and some cooling off in the recent years, gold prices have been significantly correlated to the money supply.

Now, in the last few weeks, we have been hearing central bankers talking about tightening but for now it all still looks bleak as we are talking just about a slowdown in asset purchases in Europe and slight interest rate increases in the U.S. The reason behind the announced monetary tightening isn’t so much coming from an overheating economy as it is from slowly increasing inflation. So for gold, inflation is good while higher interest rates aren’t that good. Which will prevail is the question.

Gold prices and interest rates show correlation, especially in anticipating interest rate spikes, thus higher interest rates won’t necessarily mean lower gold prices. You might wonder why that is, well it’s because the only reason central banks increase interest rates is inflation. If there were no inflation, as has been the case in the last 8 years, why would you raise interest rates as those rates give an extra push to the economy? This is extremely short-term thinking but that is how politicians, and thus central banks, usually think.

So then, if we want to find correlation between gold prices and something, we have to look at inflation. The chart is pretty telling by itself.

So as we can see above, when inflation is rising, gold prices usually rise, while when inflation is falling, gold prices usually fall too. Thus the price of gold doesn’t depend that much on interest rates nor on the FED’s balance sheet as since 2011, the FED’s balance sheet has increased significantly but gold prices have fallen.

Scenarios For Gold

So as the FED is raising interest rates due to higher inflation, we can expect gold prices to have at least some downside protection. I don’t see lower monetary liquidity as the economy is growing and it needs more money, not less. Thus while things remain like this, we can expect gold prices to have lower downside probabilities than upside, due to inflation.

Figure 4: Recent inflation in the U.S. Source: Trading Economics.

Now, an intelligent investor and trader has to be even more interested in what can happen than in what is happening. So if inflation continues to rise, we’ll probably see slightly higher or stable gold prices.

The next scenario that I want to analyze is one with a different economic environment. The thing that will eventually happen is a recession, and we simply have to be prepared for it. Despite the current bullishness by the FED and even the European dragon, ECB president Mario Draghi, a recession is always around the corner.

What will happen when a recession hits Europe or the U.S., or both? Well, more quantitative easing and lower interest rates, those are the only options. Thus greater money supply might create an environment with economic stagnation and rising inflation, a so-called stagflation. Or, there could be lower inflation but the money stock and the FED’s balance sheet could be higher, thus pushing gold prices up. In case of panic, gold prices would shoot up.

Conclusion

Now it’s important to mention that in the short-term, gold prices can go anywhere and there is always the risk that suddenly the human race renounces gold as a storage of value. That would be unlikely, but you can’t eat gold.

Apart from the general risks, the above correlations show how it’s highly probable that gold prices continue to rise in the long run alongside rising inflation and a larger money supply.

Also, all governments have high debt burdens and the best way to lower the debt or pay it back over time is to have significant inflation. Currently, gold prices haven’t really followed debt levels, but this might be another bullish sign for gold as it is highly probable that it reverts to the mean.

Thus, the long-term outlook for gold is one where the positive risks significantly outweigh the negative ones. Since the 1971 cancellation of the direct international convertibility of the U.S. dollar to gold, the trend has been pretty clear, both in monetary politics, government debt burdens, and gold prices consequently.

Now, the question at the beginning of the article was how much of your portfolio should you have exposed to gold? Ray Dalio’s advice is to have 7.5% of your portfolio exposed to gold. Given the above indications, irreversibility of monetary policies, and huge money supplies, a 7.5% allocation doesn’t seem crazy at all.

Even if gold isn’t an asset that produces value, sometimes we have to renounce production and settle for protection instead. Gold miners offer both things but the volatility and risks are much higher, you have to know what you are doing with gold miners.